BUY PUT SPREADS WITH COMMODITY OPTIONS

Let's say that you're bearish on a commodity but that all of the relevant put options are too expensive relative to your available risk capital. This can certainly happen if the commodity becomes volatile in price. What can you do?

An appealing alternative is to buy a commodity put option spread sometimes referred to as a bear put spread. A bear put spread is constructed by simultaneously buying one put option and selling another put option similar to the first but having a lower strike price. The revenue received from the put sale will lower the net cost of the put option purchased thus making the overall trade more affordable.

In fact, a bear put spread can continue to be affordable even when implied volatilities are high and even when the maturity of the component options is lengthened, since it is the difference in price between the two component options that determines the cost.

Buying a bear put spread is often less risky than buying put options both because the cost and hence, maximum loss, is less and because a spread fluctuates only very little in value with movements in the price of the underlying commodity. As such, buying a bear put spread can be an ideal strategy for the beginner or indeed for anyone seeking to trade the commodity markets while limiting risk and exposure.

The maximum possible value of a bear put spread is fixed and calculated as the difference between the strike prices of the component options. This maximum value will be realized if the price of the underlying commodity is below the strike prices of the component options of the spread at option expiration. In this case, the trade will be automatically closed and removed from the account leaving the maximum gain in cash. As the buyer or holder of the spread, you need not do anything.

Even though the maximum possible value is limited, a bear put spread can still produce excellent performance on a percentage basis. For example, in many commodity markets, it is possible to buy a bear put spread for say, $500 that has a maximum value of $1,000 generating a return of 100%.

The maximum loss is limited to the cost of the bear put spread plus brokerage commission and other trading fees. This maximum loss will be realized upon option expiration if the market price of the underlying commodity is above the strike prices of the spread. Each option will have zero value at expiration and will be removed from the trading account which closes the position. As the buyer or holder of the spread, you need not do anything.

Apart from their low risk and low cost, a bear put spread is also low maintenance. In many cases, the spread is purchased and held to expiration with no action required by the holder. In fact, management of a bear put spread is really only required if it appears that the price of the underlying commodity will settle between the strike prices of the two component put options at expiration. For more details, please see Managing the Trade under the pull-down menu, TRADING TIPS, found at the top of this page.

For a discussion of the practical considerations in buying a bear put spread for various commodity markets, please see the pull-down menu, OPTION TRADES, found at the top of this page. You can also practice buying commodity put spreads in a futures and options paper trading account found under the RESOURCES section at the top of this page along with educational books and DVD's on options trading.